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Know Your Numbers: Consumer Price Index, Part 2

One of the most widely followed economic indicators is the Bureau of Labor Statistics' consumer price index. As the first part of this article described, the CPI is more than just a compilation of prices; calculating the index requires complex statistical methods. Because the CPI is used for many different purposes, understanding of and agreement on the calculations are essential to a smoothly running economy. This part of the article turns to the ways in which various people use the CPI.

Uses of the CPIThe consumer price index is perhaps the most frequently used economic indicator. As with many other indicators, economists and analysts use CPI data to evaluate the success or failure of government and public policy to keep price inflation within acceptably low limits.

Because of the importance of price inflation to the economy, the CPI assumes even greater status as a proxy for measuring the efficiency of economic policy management. On the rare occasions when the CPI moves sharply higher, it is seen as potentially disastrous for the national economy, because it raises fears of uncontrolled hyperinflationary prices, which have crippled several other economies in recent history.

Businesses and individuals also use information on price inflation to guide their own economic decisions; in general, when price increases threaten the purchasing power of money, private businesses and individuals tend to prefer owning hard assets whose value will rise with inflation, in comparison with owning currency.

The CPI is also used for removing the effects of price inflation from other measures of economic activity. When it's used as a deflator, economists can compare the adjusted data with data from other time periods and conclude that any changes are due to factors other than price inflation. Figures adjusted for inflation are sometimes referred to as being measured in real dollars, while unadjusted data refers to nominal dollar measurements.

Perhaps most importantly, the CPI is the primary baseline by which government and private entities adjust for inflation on their payments, contract prices, and other financial figures. Each year, Social Security recipients receive an increase in their benefits based on the CPI. Civil-service pensions, food stamp benefit amounts, and the prices children pay for school lunches are also tied to the CPI. Holders of certain types of inflation-adjusted bonds, including Treasury inflation-protected securities and Series I U.S. Savings Bonds, receive interest and principal payments that are based in part on changes in the CPI. A number of income-tax figures, including tax brackets, standard deduction amounts, personal exemption amounts, and income limits governing whether taxpayers qualify for certain tax benefits, rely on the CPI for annual adjustments. In addition, private businesses often use the CPI or components within it to make automatic adjustments to price levels in contracts with suppliers. All told, the BLS estimates that more than 80 million people are directly affected by CPI changes, while the indirect effects spread outward to the entire economy.

Criticisms of the CPIThe way in which the CPI is calculated has received a great deal of criticism over the years. Some economists have argued that the CPI overstates inflation because it fails to take into account that when the price of a good rises, people tend to substitute a similar, lower-priced good. For instance, if the price of beef were to rise sharply, the CPI would incorporate the full rise into the index, but consumers would likely buy less beef and shift to cheaper foods like chicken, thereby keeping net spending on food relatively stable.

A commission led by Stanford's Michael Boskin in 1996 recommended a number of changes to alleviate the upward bias in the CPI, and the BLS implemented many of these suggestions a few years after the commission's final report.

Other critics now believe that the CPI no longer reflects the price behavior that ordinary Americans deal with every day. For instance, to measure housing costs, the CPI uses a measure called owners' equivalent rent, which basically reflects the price that one would pay to rent the house he or she lives in. Valid economic and statistical reasons exist for using this figure, but the surge in home prices in many major metropolitan areas has driven housing costs for many homeowners to levels well above the prevailing rents. Although low interest rates and creative new methods of financing have helped to lessen the impact of rising home prices on monthly mortgage payments, the recent increase in short-term interest rates will push some mortgage payments sharply upward.

Similarly, many are critical of methods that make quality-based adjustments like hedonic regression modeling. Such methods, the argument goes, are too easily manipulated and can tempt politicians to take liberties with data that makes them uncomfortable.

Finally, although the weighting of factors within the CPI likely reflects averages across the national population, it cannot accurately measure the costs that any particular individual faces. For those with health problems, for example, the CPI will fail to account for their higher medical costs. Similarly, the CPI will understate the effect of rapidly rising education costs for families with several children. The BLS admits that because the CPI is a composite index, it will not reflect the prices paid by any particular consumer, who will usually buy only a portion of the goods and services the index covers.

It's likely that no one method of calculating the consumer price index would satisfy everyone. With so much at stake, it's unrealistic to expect the majority of people to agree on a way to determine the CPI that eliminates all bias.

In summary ...The consumer price index is one of the most important releases of economic data. The CPI has a direct effect on nearly every person in the country, and although economists disagree about aspects of its accuracy, it is widely used as a measure of how well government leaders are managing the economy. By better understanding the way the CPI is determined, you can avoid misleading propaganda and focus on the valuable facts in the BLS report.

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Fool contributor Dan Caplinger is always the first to notice when gas stations change their prices. He doesn't own shares of any of the companies mentioned in this article. The Fool's disclosure policy doesn't cost you a cent.

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Dan Caplinger has been a contract writer for the Motley Fool since 2006. As the Fool's Director of Investment Planning, Dan oversees much of the personal-finance and investment-planning content published daily on Fool.com. With a background as an estate-planning attorney and independent financial consultant, Dan's articles are based on more than 20 years of experience from all angles of the financial world.
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